Global investors are focusing on the U.S. economic recovery and the supply side bottlenecks that push prices higher at a quicker pace. We recently saw April inflation in Asia pick up due to the low base from a year ago. While the big debate today is whether the Federal Reserve (Fed) should push forward its monetary policy normalization to tame inflation, the same question could be applied to Asian central banks.
We think Asian central banks are in no hurry to raise rates. First, the path of recovery is far from certain. While exports have started the year strong, domestic demand is under pressure again from fresh rounds of COVID-19 outbreaks in most economies in the region. India, Malaysia, Thailand, Singapore, Taiwan and Japan are all going through rising or high levels of infection, leading to varying degrees of lockdown. With the exception of Singapore, vaccination progress in most Asian economies is slow and, as another article in this quarter’s Asia Insights illustrates, may not reach a critical mass, or herd immunity, until 2022.
We would expect the respective governments to keep up fiscal support during such difficult times, and central banks will have to cooperate and maintain accommodative monetary policy as well.
Even if the Fed does hike rates earlier than expected in the next two years, not all Asian central banks would be obliged to follow. Since the 2008 global financial crisis (GFC), there has been a greater degree of monetary policy autonomy in Asia. This is partly because most Asian economies are running current account surpluses and have a healthy buffer in their foreign exchange reserves. Hence, they don’t need to raise interest rates in tandem with the Fed to maintain currency stability.
The two exceptions are India and Indonesia. The Reserve Bank of India and Bank Indonesia have been the most active in adjusting their policy rates since the GFC, given their currency vulnerability.
In terms of price stability, most Asian central banks would also rightfully argue that the current bout of inflation is transitory, largely driven by the low base from 2020 and energy prices returning to normal. Meanwhile, the latest challenges to domestic demand would deserve more of their attention, and the negative effect from higher prices could be temporarily offset by government fiscal support. This implies policy rates in Asia should stay put in 2021 and most of 2022.
There is also the question of asset inflation, especially in the real estate market. Instead of higher borrowing costs, regulations or macro-prudential measures could be deployed to maintain housing affordability.
Asian central banks are expected to stay put with monetary policy
EXHIBIT 1: POLICY RATES AND INFLATION IN SELECTED ASIAN ECONOMIES
A delay in economic recovery would mean Asian central banks would tolerate a short-term spike in inflation and maintain loose monetary policy to protect economic growth from the pandemic. For Asian investors, their real return from cash in local currency would stay very low, if not negative. The search for yield is likely to remain intense. They would need to make use of a broad range of tools available to generate income. This would include international corporate debt, especially high yield bonds, asset-backed securities, high dividend equities and alternative assets such as real estate.
Low domestic interest rates could also imply limited upside for their currencies against the U.S. dollar (USD), especially given the ongoing rise in U.S. Treasury (UST) yields. This could be more of a challenge for southeast Asian currencies than northeast Asian, given their recovery could take longer to turnaround. In northeast Asia, Taiwan and South Korea are driven by international demand for electronic products and components. China is led by local consumption and a range of investments directed by the 14th Five-year Plan.
For Asian fixed income, low local policy rates should help to offset some duration risks from UST and keep demand for fixed income strong. Given the more favorable environment for the USD in the near term, investors may prefer hard currency (USD) Asian fixed income instead of being exposed to local currency exchange rate risks.